What is the Marginal Tax Rate?
The marginal tax rate or MTR is the tax on the next dollar/euro/yen of earnings. Typically, MTR is the statutory tax rate in the relevant country the company operates in. Most analysts use the home country MTR. However, with global businesses, there is an argument for using an average MTR weighted by business done in various countries. The marginal tax rate for US corporations is calculated by adding the federal and state tax rates.
The marginal tax rate is used to tax adjust income statement items in the calculation of normalized net income. Normalized net income is an important metric in trading comparables and represents the recurring profit available to common shareholders. Non-recurring items are removed to calculate a “cleaned” net income figure. It also has many other applications in valuation, LBO analysis and credit analysis.
Key Learning Points
- The marginal tax rate or MTR is the tax rate on the next dollar/yen/pound of earnings
- Effective tax rate (ETR) is the tax rate observed in a company’s income statement
- Businesses are required by both IFRS and US GAAP to explain the main reasons for the divergence between ETR and MTR in their financial statements
- MTR is often higher than the ETR as it likely does not include the benefits of lower tax rates on foreign earnings. MTR also excludes any tax benefits arising from share-based compensation and any tax credits earned on certain expenses such as R&D expenses.
Here is an example of calculating the marginal tax rate.
Here, we have assumed that Company B is operating in a state with no state taxes. As a result, it has a lower marginal tax rate when compared with Company A.
For any business, tax expense should be assessed like any other expense item. Although, by nature, it is more complex than most expenses. It is driven by the legislation in the jurisdictions within which the business operates. Taxation agreements between jurisdictions further compound the complexity. The rules surrounding the treatment of businesses within the same family or group of companies also affect the tax rate. Any detailed analysis should always be undertaken with the advice of an appropriate tax expert.
MTR vs. ETR
The MTR is normally compared with the effective tax rate (ETR). ETR is the tax rate observed in a company’s income statement. The divergence between ETR and MTR is driven by the difference between the treatment of an income statement item for tax and financial reporting purposes. For example, income from a particular manufacturing plant may attract a lower than normal tax rate to incentivize employment in the area. This will reduce the average tax rate suffered by this business (ETR) when compared with the headline statutory tax rate for the jurisdiction as a whole (MTR).
The reasons for divergence between MTR and ETR are called permanent differences. Permanent difference refers to situations where an item’s tax accounting treatment is different from the treatment in the financial statements.
Under both US GAAP and IFRS, businesses are required to explain the main reasons for the divergence between MTR and ETR. This may be provided in monetary amounts or in percentage terms.
PayPal Holdings, Inc is a US corporation, and its statutory tax rate is based on both federal and state taxes. The income statement for PayPal Holding Company (below) shows the differences between ETR and the MTR for the 2017 fiscal year.
PayPal Holdings, Inc – Extract from Notes to Consolidated Financial Statements
The federal rate is 35% and the state taxes are 0.8%, giving an MTR of 35.8% (35% + 0.8%). MTR is significantly higher than the ETR of 18.4%. The impact of foreign income taxed at different rates (-25.7%) is almost exclusively driving this reduced rate.
Finding MTR in Financial Statements
We can find information on MTR in the footnotes of financial statements. Most companies have a separate note on “Income Taxes”. Some companies, like in the PayPal example above, explain the difference between MTR and ETR in percentage terms. Others include the information in monetary terms.
MTR vs. ETR: Implications for Valuation (DCF method)
The method uses free cash flows to arrive at a company’s valuation. Free cash flows are affected by the tax rate used. As seen above, at times, there can be a substantial difference between the ETR and MTR. Using a lower tax rate can increase the free cash flows, thereby increasing the valuation. So, a question is which tax rate to use for valuation?
The approach depends on how long the permanent differences in MTR and ETR will continue. If the differences are expected to continue permanently, analysts will use a long-term ETR. If the differences are going to last for short periods only, many practitioners will use the MTR.
Application of MTR in Trading Comparables
In the trading comparables method of valuation, earnings per share (EPS) is a key value driver of the business being valued. EPS is calculated using net income (after taxes). A higher net income, and thereby a higher EPS, leads to a higher valuation and vice versa. Analysts make projections about the net income in future periods to arrive at the value of a business. A key step in this process is to clean the net income and remove the effects of any non-recurring items.
Here is a simple illustration:
This is the income statement of a company being valued. Including the effect of the non-recurring expense of 20 million, the business has a net income (after taxes) of 126 million. An analyst valuing the company would like to remove the effect of this non-recurring item to value the business fairly. However, this 20 million cannot be added directly. It needs to be adjusted for taxes. The marginal tax rate is used for such adjustments. In this example, using the marginal tax rate, the analyst will add another 14 million to this company’s net income. They will use a net income of 140 (126+14) for valuation purposes.